Cutting taxes not an effective remedy to accelerate slow economy in short-term, households should focus on higher spending

The government has started the process of reforms with new policy announcements on a periodic basis addressing sector-specific issues and is now in fifth gear. The first few sets of measures involving the reversal of tax decisions, incentives to the auto industry, foreign direct investment (FDI), bank mergers and export/housing incentives did show that the government was sincere and persevering but the latest move on the corporate tax cut is probably the most convincing move.

This is so because going by the finance minister's estimate of the loss of revenue of Rs 1.45 lakh crore, this is the first measure that actually puts money on the table. If the government is losing this much revenue, then the beneficiary is saving on the same and hence means it is party time considering that overall corporate tax collections for the year are to be Rs 7.66 lakh crore. Will this work?

Tax saved is profit earned and the important thing is how this money is used by the companies assuming that every company will weigh the new tax rate of 25.17 percent with the existing structure which includes exemptions.

Representational image. Reuters

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There are several choices here. First, the higher net profit may be used for paying higher dividend. Second, it could be transferred to reserves with nothing else being done. Third, the same could be used for further investment which will help the growth process.

Fourth, if it is a public sector undertaking (PSU) concerned, the amount can be used for the disinvestment process where one of them buys into another with their retained profit. The final result will depend on how the company’s management decides to use the money.

More importantly, for FY20, the profit levels would be important too as the Q1 performance has not been exciting, and the outlook for the rest of the year is at best sanguine with few signs of a major turnaround across all sectors. It is more likely to be localised.

It is not surprising that the stock markets have reacted positively since this means that companies have more net profit in relative terms which in turn means higher dividend payouts or higher earnings per share (EPS) and the return on net worth (RONW) ratios which helps the cause. Also, the fact that the government has lowered the rate even below 25 percent which was the promise made in 2014-15 shows the progressive mindset where the rate has been brought down to comparable levels as in other countries which is positive for corporate sentiment.

The impact in investment would, however, be felt over the next few years and not immediately. To begin with, demand conditions are low and with excess capacity in many industries the need to borrow has come down. This is one reason why the demand for credit is low. Conditions need to change for companies to think of investing. But with this lower tax rate, the benefits will accrue in the next few years when the economy revives and companies use their own funds to finance investment.

As the financial system is still grappling with the issue relating to liquidity for non-banking finance companies (NBFCs) and non-performing assets (NPAs) for banks companies will prefer to dip into their retained earnings to partly finance capital expansion plans.

However, foreign investors should be enthused by this move as it would make their investment more profitable. Here, the benefit to the new startups which will have a rate of 17.01 percent instead of the existing 25 percent plus surcharge/cess is significant as these enterprises would also be progressively sourcing foreign investment. Also the reduction in minimum alternate tax (MAT) from 18.5 percent to 15 percent would benefit the concerned companies.

Could the government have done it differently? Assuming that the government was taking a hit of Rs 1.45 lakh crore, the option was to go for a direct stimulus of higher expenditure. That would have meant spending more on roads, railway, power, transport, urban infrastructure and the like. This gives a direct impetus to the sectors concerned and forges strong backward linkages.

Cutting taxes has the same fiscal impact but takes time to work out as it is conditional on companies investing part of the gains. Also if the company involved is in the financial sector there is practically less scope for investment and the monetary gain would flow into reserves or paid out partly as dividend. Therefore, the impact of a tax cut is relatively less effective than an expenditure impetus.

However, tax cuts involving loss of revenue is looked at positively by international agencies like credit rating companies and multilateral agencies as they are seen as tax reforms which are required for efficiency. Running fiscal deficit due to higher expenditure is criticised as being straying from the path of prudence. Hence the global perception is positive when it comes to tax rationalisation relative to higher spending.

It would be interesting to see how this loss is compensated for in the Budget. The Reserve Bank of India (RBI) surplus of Rs 58,000 crore will help or there could be drawn down from the cash balances or greater recourse taken to the National Small Savings Fund (NSSF). But the fiscal deficit ratio is bound to stray from the 3.3 percent mark to up to 3.8 percent on this count.

Tax cuts as per the tenets of the famous Laffer curve were the route to higher growth as savings in tax was theoretically the way to get companies to invest more which in turn would lead to more jobs, consumer spending and hence economic growth. But this theory assumed that companies wanted to invest and were not in a position to borrow much due to leverage issues. This was the path followed by the US when Ronald Reagan was the President where these cuts were accompanied by higher spending too which came to be called Reaganomics. Even when Donald Trump came to power, the focus was on both tax cuts as well as higher spending on infra. It appears that we have opted for the first part of the policy.

Can we expect cuts in income tax rates now? This is a natural corollary as the problem today is on the consumption side and households need to spend more. Cutting taxes could be a way out, though again it cannot be taken for granted as when consumer sentiment is low, the lower tax paid could flow into savings, which though good for the economy may not lead to higher spending. This is a chance which policymakers have to take.

(The author is chief economist, CARE Ratings)